ira Tag

by Chris Swiecicki

Tax Court Holds Form Over (Controlled) Substance

I am again both proud and honored to be co-author with Richard Wise on this article, which first appear in the St. Louis Bar Journal. Any errors are mine alone. Readers who want the full version, complete with footnotes, should check out the original published by the Bar Journal.

In 2017, Lonnie Wayne Hubbard, a pharmacist from Kentucky, was found guilty by a jury on multiple charges of distributing a controlled substance. The indictment included a forfeiture provision with respect to the pharmacist’s listed property, more specifically an Individual Retirement Account held at T. Rowe Price. Following the defendant’s jury trial, his IRA was condemned and forfeited to the United States.

T. Rowe Price issued Hubbard a Form 1099–R: Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., for the 2017 tax year, reporting an early taxable distribution in the amount of $427,518.00. For 2017, Hubbard did not file an income tax return, thus failing to report the $427,518.00 IRA distribution which was forfeited.

The Internal Revenue Service via its Automated Substitute for Return Program, authorized by § 6020(b) of the Internal Revenue Code, prepared a substitute tax return on behalf of the taxpayer.

In 2020, the IRS sent a notice informing Hubbard of an income tax deficiency for the 2017 tax year of $165,353, an addition to tax of $37,204.00 for failure to file a timely tax return, an addition to tax of $28,937 for failure to timely pay, and an addition to tax of $3,959 under for failure to make estimated tax payments for 2017. In 2021, Hubbard timely filed a notice of petition with the Tax Court contesting the tax deficiency.

Hubbard’s argument was that since the funds were directly transferred to the government, he never constructively received the funds. Furthermore, he argued that he had reasonable cause for not filing his tax return, as he was incarcerated at the time the tax return was due. Lastly, he argued that his wife (now his ex-wife) never forwarded him the Form 1099-R received from T. Rowe Price.

Constructive Receipt

Section 61(a) of the Code provides that gross income includes “all income from whatever source derived.” This includes all accessions to wealth, clearly realized, and over which the taxpayer has complete dominion. Pensions and IRA distributions are generally taxable as income.

Gross income under § 61(a) includes items of income that the taxpayer has constructively received. Under the constructive receipt doctrine, funds or property which are subject to a taxpayer’s unfettered command and which they are free to enjoy at their option are constructively received whether they see fit to enjoy them or not.

Where a taxpayer’s funds are criminally forfeited to the United States to satisfy a forfeiture judgment, the taxpayer is not relieved of the income tax consequences that would have attached to the funds without such forfeiture. By forfeiting the funds, the taxpayer has realized the benefits of the funds, and must recognize the funds as gross income to the same extent as if they had been physically received.

The courts have held that a discharge by a third person of an obligation is equivalent to receipt by the person taxed.

In addition, the courts have previously held that IRA funds constitute gross income as an involuntary distribution when forfeited to a third party. A taxpayer constructively receives the IRA distribution when the distribution is made from the taxpayer’s IRA to satisfy a fine or restitution related to criminal conviction.

In the present case, there were undeniable accessions to wealth, clearly realized, and over which Hubbard had complete dominion. The mere fact that the payments were extracted as punishment for his unlawful conduct did not take away from their character as taxable income to him.

Excuses Not to File Petitioner’s Tax Return

Sections 6651(a)(1) and (2) of the Code provide that additions to tax may be reduced if petitioner can establish that his failure to timely file or failure to timely pay was due to reasonable cause and not willful neglect. Hubbard argued that he had reasonable cause not to file his tax return because he was incarcerated.

This argument failed, as the Tax Court held that Hubbard knew that he had a duty to file his tax returns. The Tax Court took judicial notice that Hubbard had filed his tax returns in previous years, and that he was aware of the criminal forfeiture. The Tax Court relied on Commissioner v. George, in which it was held that incarceration is not reasonable cause for the failure to file an income tax return.

Lastly, the court addressed Hubbard’s claim that he did not know that he had to file an income tax return because he did not receive the Form 1099-R from T. Rowe Price. Failure to receive tax documents does not excuse taxpayers from the duty to report income, and the courts have held that non-receipt of a tax document does not constitute reasonable cause to prevent the application of a § 6662(a) accuracy-related penalty.

Conclusion

In conclusion, Hubbard had no better luck in his proceedings in Tax Court than he did in his unlawful distribution of controlled substances.

This piece originally appeared in the St. Louis Bar Journal blog.

by Chris Swiecicki

Sonny Did Not Rollover: Some Perils of Holding and Transferring Nontraditional Assets in IRAs

I was delighted when asked to be co-author with Richard Wise on this article, which first appear in the St. Louis Bar Journal. Richard is a wealth of information on many topics, and I was happy to contribute my two cents on this particular case. Readers who want the full version, complete with footnotes, should check out the edition published by the Bar Journal.

With the popularity of using Individual Retirement Accounts (IRAs) to hold non-traditional assets such as precious metals, partnership interests, real estate, and other property, a recent case involving James Caan, the actor who played Santino Corleone (better known as Sonny) in the movie The Godfather, illustrates some of the perils of using IRAs to hold non-traditional assets.

What is an IRA?

Section 408 of the Internal Revenue Code is the main Code provision governing IRAs. It was enacted as part of the Employee Retirement Income Security Act of 1974, in furtherance of Congress’s goal “to create a system whereby employees not covered by qualified retirement plans would have the opportunity to set aside at least some retirement savings on a tax-sheltered basis.”

Section 408(a) provides that an IRA is “a trust created or organized in the United States for the exclusive benefit of an individual or his beneficiaries, but only if the written governing instrument creating the trust meets the [requirements enumerated in paragraphs (1) through (6)].” Section 408(h) further provides that for purposes of section 408:

a custodial account shall be treated as a trust if the assets of such account are held by a bank (as defined in subsection (n)) or another person who demonstrates, to the satisfaction of the Secretary, that the manner in which he will administer the account will be consistent with the requirements of this section, and if the custodial account would, except for the fact that it is not a trust, constitute an individual retirement account described in subsection (a). For purposes of this title, in the case of a custodial account treated as a trust by reason of the preceding sentence, the custodian of such account shall be treated as the trustee thereof.

To form a custodial IRA, the taxpayer executes a written custodial agreement that meets the requirements specified in section 408(a)(1) through (6). Once the custodial agreement is executed, section 408(h) treats the custodial agreement as a trust instrument and the custodian as a trustee, which allows for section 408(a) to apply, thereby creating a custodial IRA.

If the IRA is a custodial account, the institution’s duty is to hold and safeguard the investment; there is no duty with respect to investment decisions. The practical distinction is that a custodial account’s investment decisions can be dictated by the IRA owner/beneficiary.

Trust IRAs and custodial IRAs have the same three tax attributes, which together constitute the tax- deferral system that Congress created: (1) cash contributions are generally deductible; (2) accretions from the IRA’s assets are not taxable (except for Section 511 unrelated business income); and (3) distributions are taxable.

Alternative/Nontraditional Asset

IRAs are not limited to holding traditional assets such as cash, bonds, and publicly traded securities; they can still qualify for tax advantages while holding alternative assets.

When an IRA holds alternative assets, however, the IRS requires that the IRA’s trustee or custodian report the fair market value of the alternative assets yearly, valued as of December 31 of the preceding year, i.e. year-end fair market value.

Distributions from an IRA

In addition to creating a tax-deferral system through IRAs, Congress provided for nontaxable rollovers of IRA distributions, by which taxpayers can transfer investments from one IRA to another without incurring tax liability.

When a taxpayer requests an IRA distribution, that distribution is nontaxable if the entire amount received, including money and any other property is paid into an IRA for the benefit of such individual not later than the 60th day after the day on which he receives the distribution.

A taxpayer may also choose to roll over only a portion of the distribution, in which case only the portion that is contributed to another IRA within the 60-day rollover period qualifies as a nontaxable rollover contribution, and the non-contributed portion must be included in income.

Taxpayers are limited to one nontaxable rollover of an IRA distribution per one-year period, whether it be a full or partial rollover.

Distributions of Noncash Property

If the distribution consists of noncash property, the taxpayer must contribute the exact same property in order for the distribution to be considered a nontaxable rollover contribution under section 408(d)(3)(A)(i). In other words, the taxpayer cannot change the character of the noncash property.

Sonny’s Predicament

Caan held a partnership interest in an IRA with UBS serving as the IRA custodian. As part of the UBS custodial agreement, UBS placed the responsibility with Caan to provide a year-end fair market value of the partnership. In 2015, Caan failed to provide UBS with the partnership’s 2014 year-end fair market value. As a result, UBS refused to continue serving as the custodian of the partnership interest, and sent a letter to Caan notifying him of a distribution of the partnership Interest. UBS then issued Caan a Form 1099–R – Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., which reported to the IRS a distribution of the partnership Interest using the 2013 year-end value as the value of the distribution.

Also in 2015, Caan’s financial advisor moved to Merrill Lynch and Caan transferred his IRAs to Merrill Lynch. The partnership interest, however, was not eligible for electronic transfer, so Caan’s investment advisor at Merrill Lynch directed that the partnership be liquidated, and the cash sent to Caan’s Merrill Lynch IRA account. Said liquidation and cash transfer did not occur until approximately a year from the time that UBS notified Caan of UBS’s distribution of the partnership interest.

On his federal income tax return for tax year 2015, Caan reported a nontaxable distribution of his IRA. The IRS Commissioner disagreed with Caan’s position and determined an income tax deficiency of $779,915.00 for tax year 2015. He filed a petition with the U.S. Tax Court for redetermination of his 2015 income tax deficiency.

Shortly before filing the Tax Court petition, Caan requested a private letter ruling from the IRS granting him a waiver of the 60-day period for rollovers of IRA distributions. The IRS denied that request on the grounds that Caan did not meet the “same property” requirement. In other words, regardless of the timing of the rollover, Caan’s liquidation of the partnership interest and contribution of the cash to the Merrill Lynch IRA did not comply with the “same property” requirement. As such, it was not a nontaxable rollover.

The Tax Court sided with the IRS, holding that the partnership interest was distributed in 2015 to Caan, and that Caan did not contribute the partnership interest in a manner that would qualify as a nontaxable rollover contribution under section 408(d)(3) because he changed the character of the property when the partnership interest was liquidated prior to rolling over the property to his new IRA.

Takeaway

When a client holds nontraditional or alternative assets in an IRA, the IRA should be reviewed yearly, and any actions involving rolling over such assets to a different custodian must be taken with care.

This piece originally appeared in the St. Louis Bar Journal blog.